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The Simplest Test of Target Zone Credibility

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  • Svensson, Lars E O

Abstract

Under the assumption of no arbitrage, exchange rate target-zone credibility is tested by whether domestic interest rates fall within `rate-of-return bands' between the maximum and minimum home-currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest rate parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. Under the assumption that devaluations are a Poisson process, the expected exchange rate, the probability intensity and the expected size of a devaluation can be related. These tests are illustrated using data on the Swedish target zone between January 1987 and August 1990.

Suggested Citation

  • Svensson, Lars E O, 1991. "The Simplest Test of Target Zone Credibility," CEPR Discussion Papers 493, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:493
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    References listed on IDEAS

    as
    1. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 87-116, August.
    2. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
    3. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Credibility; Devaluation Risk; Exchange Rates; Interest Rate Bands; Target Zones; Term Structure;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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